Insulation vs. Insurance
by Arnold Kling
January 8th, 2007
Question: How many American families have proper health insurance?
a) over 90 percent.
b) between 80 and 90 percent.
c) between 10 and 80 percent.
d) less than 10 percent.
Given that about 15 percent of American families do not have health insurance, the correct answer would appear to be (b). However, in my opinion, the correct answer is (d).
The health coverage most Americans have is what I call “insulation,” not insurance. Rather than insuring them against risk, most families’ health plans insulate them from paying for most health care bills, large and small.
Real insurance, such as fire insurance, provides protection against rare, severe risk. Real insurance is characterized by:
– low premiums
– infrequent claims
– large claims
American health insurance—including employer-provided insurance and Medicare—is the opposite. Families typically are paid claims several times per year, often for small amounts. Premiums are high—the cost of providing insulation often exceeds $10,000 per year per family. However, most families pay these premiums only indirectly, through taxes and reduced take-home pay from employers.
Real insurance would pay for treatments that are unavoidable, prohibitively expensive, or for illnesses that occur relatively rarely. Instead, insulation reimburses even relatively low-cost services, such as a test for strep throat or a new pair of eyeglasses. Insulation pays for treatment even if it is commonplace or discretionary.
What is Wrong with Insulation?
For health care providers, insulation is a bonanza. Because consumers are not spending their own money, they accept doctors’ recommendations for services without questioning them and without concern for cost. Faced with an insured patient, a health care provider is like a restaurant catering to convention-goers with unlimited expense accounts. The customer will gladly take the most high-end recommendation and not worry about the price.
Consumers are happy as well. Insulation relieves the patient of the stress of making decisions about treatment. The patient also does not have to worry about shopping around for the best price.
The problem with insulation is that it is not a sustainable form of health care finance. Individuals, employers, and government are all under stress.
Families that are in the individual insurance market face sticker shock when they confront health insurance premiums. Many choose to remain uninsured.
Employers are finding health care expenses an increasing burden. A noticeable gap has arisen in the past twenty years between the growth of total employee compensation and the growth of wages. Take-home pay is stagnant or shrinking, as much of the growth in compensation is diverted to health care.
Medicaid has become the largest item in many state budgets. Medicare is responsible for America’s biggest long-term fiscal crisis, with a looming gap between promised benefits and expected tax revenues rising to several percent of GDP per year in the middle of this century.
From an economic standpoint, insulation is both inefficient and inequitable. It allocates too many resources to health care, and it includes regressive subsidies that flow up the income scale.
Insulation leads people to over-consume health care services. Americans make extravagant use of services that have high costs and low benefits. Many studies that compare groups with similar conditions show that those with the largest levels of health care spending fare no better in terms of outcomes than those that spend less.
Insulation is also inefficient because of the large taxes that it requires. Payroll taxes support Medicare. Income taxes support Medicaid. Moreover, income tax rates are higher than they would be otherwise, because employer-provided health insurance is a deductible expense for companies but is not taxable income to employees. Taken together, higher payroll and income taxes to support insulation discourage work and thrift, leading to what economists call a “deadweight loss” to the economy.
Insulation also is inequitable. Millionaires on Medicare have their treatments paid for by taxes on low-income workers. High-income earners derive relatively more benefit than low-wage workers from the tax exemption of employer-provided insulation from health expenses.
We Have Had Insulation for Several Decades. Why Is It a Problem Now?
Today, over 85 percent of our health care spending is paid for by third parties—either private health insurance or government programs. America has one of the highest rates of insulation in the world.
At the same time, and partly in response to the bonanza provided by insulation, medical specialization and medical technology have surged. In my book, Crisis of Abundance, I call this phenomenon premium medicine. Primarily because of premium medicine, the share of our income devoted to health care in this country has roughly doubled over the past 30 years, from about 8 percent of GDP to about 16 percent of GDP.
Sometimes our skilled specialists and advanced technology make a difference for patients, extending lives and alleviating suffering. Often, however, services are provided that make no difference. The MRI exam that I had when I hurt my back moving furniture was pointless—the treatment would have been rest and anti-inflammatories, whatever the exam showed. My doctor’s referring me to a nephrologist for microscopic hematuria (blood in a urine specimen not visible to the naked eye) was equally pointless—like many people, I have this symptom sometimes, and then it mysteriously goes away.
We have accumulated a dazzling array of human and physical capital, and we are developing a culture that insists on using it to the fullest extent. The use of medical services well beyond the point of diminishing returns is what is driving up our health care costs and making it difficult to finance individual insurance, employer-provided insurance, and our government programs.
Can We Solve Our Health Care Crisis by Being More Efficient?
By definition, our health care system would be more efficient if we could deliver the same health care services at less cost. While greater efficiency is certainly possible and desirable, it would not relieve the stress in health care finance.
For example, pundits such as New York Times columnist Paul Krugman claim that private health insurance is inefficient due to overhead. However, even if one eliminated all of the overhead in health insurance, this would reduce total health care spending by about 1 percent of GDP, still leaving us spending 15 percent of our GDP on health care, about 5 percentage points more than most other countries.
Moreover, any gain in efficiency would not slow the growth of health care spending, which is driven by the ever-increasing supply of premium medicine in the context of unchecked demand. The only reliable way to slow the growth of health care spending is to slow the rate of increase in consumption of premium medicine. We cannot address the problems caused by the extravagant use of health care services that have high costs and low benefits by trimming the overhead expense involved in delivering these unnecessary services.
Other countries spend less of their GDP on health care, with little apparent difference in health outcomes. (Note, however, that the standard measure of health care outcomes—average longevity—is a flawed indicator, because it ignores many benefits of health care and does not take into account other factors that influence lifespan.) This is because premium medicine is less available in those countries, and the constraints on supply limit the extravagant use of procedures with high costs and low benefits. For example, the use of colonoscopy to screen for colon cancer in healthy patients over 50, as recommended in the United States, is not possible in Canada, due to the scarcity of equipment and trained personnel. Yet this may make relatively little difference in average longevity, because colon cancer tends to emerge late and to move slowly, so that many of its victims die of other illnesses first.
How Would Real Health Insurance Work?
Real health insurance would pay claims to people who come down with expensive illnesses. Typically, these expenses accumulate over a period of years.
In Crisis of Abundance, what I have suggested is a health insurance policy that you buy this year, but reimburses you in five years, based on cumulative expenses. Such a policy might pay nothing if your total expenses over the next five years are less than $30,000. It might pay 100 percent of expenses thereafter.
For example, if I buy a policy in January of 2007 and my expenses from 2007 to 2011 total $35,000, I would be reimbursed for $5000. The policy that I buy in January of 2008 would reimburse me based on expenses that I incur from 2008 to 2012, so that if my expenses for that period were $33,000, then I would be reimbursed for $3000.
These overlapping five-year policies would provide a better safety net than the annual policies that we have today. The typical catastrophic illness does not stop requiring treatment on December 31.
However, there are other ways to implement real health insurance that are worth considering. For example, one could have a health insurance policy where you make a claim when you are diagnosed with an expensive condition. First-stage breast cancer might result in a $25,000 payment. A heart condition requiring major surgery might result in a $40,000 payment. And so on. Only major medical problems would trigger claims, and payments would be for fixed amounts, not for reimbursement for procedures.
Real health insurance would not require high premiums. Fewer people would be discouraged from obtaining insurance by sticker shock.
It is not just private health insurance that needs to be changed if we are to move to real health insurance. Medicare would have to change as well. Instead of the insulation of Medicare, real health insurance for the elderly might be what I call “Remaining Lifetime Care Insurance.”
Between age 65 and death, medical expenses average a total of $100,000 per person. However, even if an individual saves $100,000 by age 65, the individual still needs protection against unusually large expenses. At age 65, you might keep $75,000 to pay for expenses out of pocket, and then spend $25,000 on an insurance policy with a remaining lifetime deductible of $75,000. That insurance policy only pays when the expenses that you accumulate after age 65 exceed $75,000. However, it guarantees that your out-of-pocket medical expenses will not exceed $75,000.
With these sorts of policies, individuals would be protected from extreme financial loss. However, they would be insulated from much less of their health care expenses than they are today. In fact, some simulations I performed using the government’s Medical Expenditure Panel Survey showed how it might be possible to increase the share of out-of-pocket spending from 15 percent to over 50 percent, while still providing a safety net to the very poor and the very sick.
Having individuals pay for more of their own health care would be more efficient. It would reduce the disincentives to work and thrift caused by the collectivization of health care spending. It would also make individuals less inclined to undergo procedures that have high costs and low benefits. Consumers also would have the incentive to engage in comparison shopping when they encounter outrageously high charges from providers.
Can Consumers Make Reasonable Health-Care Decisions?
One common objection to real health insurance is that it is too burdensome for individual consumers to make health care decisions based on costs and benefits. The argument is that if we switch from insulation to insurance, then consumers will make bad decisions.
Harvard University health care economist David Cutler, in a conversation with economists at Cato, made such a point. He said that consumers do not really differentiate between necessary and unnecessary health care. As a result, he predicts that if consumers have to pay for more health care out of pocket, they will cut back proportionately on both cost-effective and cost-ineffective health care. Wasteful spending will decline, but so will useful spending. Ultimately, consumers’ health will suffer.
My view is that the solution to this potential problem is better information for consumers. I have endorsed the idea of a commission, perhaps with government funding, to study medical protocols in order to provide guidelines for what is typically cost effective.
How Would We Get There Institutionally?
Many government policies favor insulation rather than real health insurance. Changing these policies would help to encourage a transition to real health insurance.
State laws concerning health insurance tend to encourage comprehensive insurance. Lobbyists push for laws requiring insurance to cover treatments. These might include eye care, dental care, or fertility treatments. Such laws or regulations are inconsistent with insurance that is designed to protect against catastrophic illness.
Federal and state tax laws allow individuals to “launder” their health expenses through their employers in the form of comprehensive health insurance. We should reform the current system, in which employer-provided health insurance is deductible to companies but not included in individual compensation. One approach would be to count employer-paid premiums as compensation, or to put a cap on the amount of employer-paid premiums that would be tax exempt.
For people under 65, government should provide a safety net that is consistent with real health insurance. People who cannot afford to pay for health care will require government support, even to obtain basic services. People who have already been diagnosed with expensive illnesses probably will need a government subsidy in order to obtain real health insurance. Perhaps what some economists have called “catastrophic reinsurance,” in which government would pay all expenses above, say, $50,000 in a year, would enable the very sick to obtain health private health insurance. In any event, apart from the very poor and the very sick, government need not be involved in paying for health care.
Ultimately, people over 65 should be paying for health care out of savings. This means that Medicare ought to be phased out. I have proposed doing so by gradually raising the age of eligibility for Medicare. The age would stay the same for people currently on the verge of becoming eligible. It would rise somewhat for people in their 40s and early 50s. It would be raised considerably more for people now in their 30s, and Medicare would be phased out altogether for people under age 30.
How Would We Get There Culturally?
Today it is fairly deeply ingrained with most Americans that health care services are something that you should not have to pay for yourself. Insulation is the norm, and real health insurance as I would define it is almost nonexistent.
Suppose that we were to remove the tax benefits and other institutional supports for insulation. It is by no means certain that what would emerge instead would be real health insurance.
It could be that if health insurance were relatively unregulated and unsubsidized, then many people would opt to do without health insurance. This raises the issue of people “free riding” by doing without health insurance while healthy and then turning to government assistance when illness or injury occurs. It is to address this free-rider problem that some analysts propose making health insurance mandatory. This is a controversial idea, not well received at Cato. In any event, it is very difficult to justify a mandate for insulation, rather than a mandate for something closer to real health insurance.
Ultimately, I think we are headed for a collision of cultural values. We prefer insulation to real insurance. We expect services to be readily available, without the supply limitations or waiting lists that exist in countries where government is responsible for more health care funding. And yet we are growing increasingly concerned over the expansion of health care spending that takes place in a system that lacks constraints on either supply or demand.
Real health insurance may not be popular now. But when Americans see that the providers of insulation, including Medicare, have to turn to the rationing of health care services in order to meet budgetary constraints, real health insurance may start to look like a good alternative.
January 8th, 2007 at 10:44 am
Too much coverage
Kling:
The health coverage most Americans have is what I call “insulation,” not insurance. Rather than insuring them against risk…
January 8th, 2007 at 4:34 pm
[...] This month’s Lead Essay by Arnold Kling goes through all the mechanics of what he believes market-based health insurance would look like (which he refers to, surprisingly, as “insurance”) and what is wrong with the current system of going to your doctor any time you get a hangnail (described as “insulation”). [...]
January 10th, 2007 at 1:59 pm
The Problem With the Problem With Insurance
Predictably, Cato Unbound has another great lead essay this month - Arnold Kling’s Insulation vs. Insurance which talks about the state of the health industry and why the current model of all-encompassing health care is unsustainable.
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January 10th, 2007 at 2:50 pm
[...] How sick am I, exactly? Posted in Politics, Economics by hktelemacher on the January 10th, 2007 First and most importantly, is anyone but me having trouble with Cato Unbound’s trackback system? My last post should have connected via trackback to the Lead Essay, but I got nothing. It’s happened before, and I’ve rectified it in the past by reposting–the trackback feature has in the past worked fine the second time, but it didn’t this time. [...]
January 15th, 2007 at 9:52 am
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Consumer-Driven Health Care III
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January 30th, 2007 at 1:15 am
[...] Here, by the way, is a provocative free market perspective on the problems with American health care - the problem of confusing “insulation” with “insurance” — by Cato Institute scholar Arnold Kling. [...]
February 11th, 2007 at 4:23 pm
[...] Consider health care, Godfather. The National Center for Policy Analysis reports that patients pay only 14 percent of costs out-of-pocket. Paraphrasing economist Arnold Kling, this is cost-insulation, not insurance. Between 1992 and 2005, medical-service prices increased by 77 percent while the Consumer Price Index rose only 39 percent. The cost of cosmetic surgery, an uninsured medical procedure, increased only 22 percent despite booming demand. And yet, the RAND Health Insurance Experiment concluded that low deductibles increases consumers` spending, but not their health. [...]
June 20th, 2007 at 11:32 pm
[...] I agree with the post’s author that there isn’t an easy solution. This story highlights the intersection of two issues that are roiling the national political waters and doubtless will be key points in the presidential race, healthcare and illegal immigration. I think the answer to the healthcare problem has to include reform that divorces the idea of health insurance from employment and also changes the perception that people have of what health insurance should cover (see this article comparing insurance and “insulation”). But I don’t know if our society, with so many who look to the government to be the solution for every problem, is going to be willing to go through the difficult transition such a change would require. The idea of universal healthcare, guaranteed by the government, is a much easier sell politically, even though it is driving most of the countries that currently have it to financial ruin. And perhaps the more pressing problem in Houston, which is a city that thrives on immigration, is the illegal immigrant problem. Doubtless they have some economic benefit to society with the cheap labor they provide, but the drain on education, social services and law enforcement are all costs that are borne by the rest of us. The U.S. should have a strong policy of encouraging immigration, but it should be on terms that the nation can control and enforce, which is another way of saying that before any reforms can be implemented on the system that allows people to come here, we need to be able to stop people from coming illegally and discourage the ones already here illegally from staying. [...]
August 13th, 2007 at 9:51 am
[...] Arnold Kling challenges the assumptions. He seems taken in by the lower-prices-by-removing-licensing-restrictions argument (which would work only in a free market, which we don’t have), but he has some thought-provoking ideas: The Universal Distraction (HT: Maggies Farm) See also his excellent article on Insulation vs. Insurance — although if he had bladder cancer (a common disease), ignoring his microscopic hematuria would have been a very bad idea. [...]
October 3rd, 2007 at 11:25 am
[...] was my gripe, too, with Arnold Kling’s article on healthcare from earlier this year. Insulation leads people to over-consume health care services. Americans [...]